Homeland Insecurity?

Homeland Insecurity?...To ourselves, the single most important issue
for the real US economy and financial markets in 2007 is the fate of US residential
real estate and the credit markets that support this asset class. Despite all
the claims by the Fed that current weakness in housing is "isolated", without
sounding too simplistic, we know that historically the character of the housing
cycle has indeed had a direct impact on US payroll employment and consumer
spending behavior. In other words, at least according to the message of historical
experience, housing is anything but isolated. It's an integral part of the
ongoing rhythm of the real economy. So as we look into 2007, we suggest that
the changing nature of the housing cycle will be very important to real world
economic outcomes as well as financial market outcomes. But at least within
the context of the current cycle, we believe it's also very important to keep
in mind that the changing character of the housing cycle will impact monetary
action in perhaps a very big way. In fact, we think this has already started
in terms of the Fed being incredibly accepting of ongoing systemic liquidity
creation, especially since the summer of last year. Despite the fact that the
Fed/Treasury/Administration talks a good game in terms of theoretically being
vigilant regarding ongoing inflationary pressures, they are anything but monetary
policemen as they are indeed the key provocateurs in monetary expansion (otherwise
know as monetary inflation). And given that less and less current financial
liquidity is finding its way into the real estate markets, that brings up the
possibility that once again monetary excess will find its expression in the
financial markets. Can we make the case that the worse it gets for the real
world housing cycle, the greater the possibility that liquidity excess allowed
to be generated as a counterpoint to the deterioration in housing may impact
the financial markets? Moving into 2007, we believe these are the very simple
macro dynamics perhaps most important to investment survival.

In the spirit of trying to keep our finger on the reality of the housing cycle
and anticipate monetary actions to come, we thought we'd very briefly review
current housing cycle dynamics relative to historical experience in an attempt
to get a sense for where we are and what may be to come. For anyone who has
tuned into the ongoing infomercial that is CNBC as of late, and actually allowed
the volume to be turned up, you already know that the favorite pastime of so
many of the current commentators spewing "information" on this media platform
has now become calling the bottom for the housing cycle. Without question,
we fully expect this to continue throughout the year to come and perhaps well
beyond. For as you know, we witnessed exactly the same experience six short
years ago in yet another asset class when headline and mainstream commentators
repeatedly attempted to call the bottom for the tech cycle and its related
stocks. But we all know, or should know, how and when asset class cycles truly
bottom, right? They bottom when no one is any longer calling for the bottom.
They bottom in silence. In terms of housing? At least according to the relatively
important cacophonous CNBC chorus of the moment, we're not even close to a
bottom. But, as always, that's our opinion. Let's look at the facts, shall
we?

Bottoms Up?...So where do we start? With starts, of course. To try
to maintain our bearings, we want to have a quick run through the history of
residential real estate cycles of the past 45+ years by having a look at housing
starts and permits. We ask you, what could be more fundamental and crucial
data points for the industry as a whole? (Answer: Not much.) Okay, this is
what we've put together. We've gone back and looked at both depth and duration
as applied to the history of housing permits and starts data. We're documenting
duration (monthly) of peak to trough cycles in terms of starts and permits.
And lastly, we've calculated percentage declines in starts and permits over
all down cycles. For each we start off with a long term chart followed by a
quantitative table that's essentially documenting what you see in the charts.
First at bat is the historical cycle of housing starts:

You already know that in the most recent residential real estate cycle we
lived through the longest duration in the up cycle for starts on record. It's
more than clear above. It just so happens that the recent peak in housing starts
was seen in January of 2006, as you'll see in the table below. We're maybe
eleven months into the decline. What does history tell us to expect? Just have
a look.

Historical Housing Starts Cycles

Peak

Trough

Duration

% Decline

2/64

10/66

30 mos.

54.0%

10/72

2/75

28 mos.

63.6

4/78

11/81

43 mos.

61.9

2/84

1/91

83 mos.

64.7

AVERAGE

46 mos.

61.6%

1/06

?

11 mos. so far

29.9% so far

The average cyclical peak to trough decline in starts historically spanned
a 46-month time frame. The shortest contraction on record over the past 45
years was twenty-eight months. Can it really be that the current down cycle
is done after only eleven months? We think not. Moreover, the average percentage
decline in starts from cycle top to bottom historically has been just shy of
62%. So far our current experience has been 30.0%. There's no question that
the recent cycle has seen a very steep drop over a compressed period of time,
but common sense tells us this is nothing unusual given the prior unprecedented
up cycle length. In the past we've pointed out to you the literal unblemished
consistency in cycle bottoms at or below 900 thousand in every cycle since
1960. Do we now really bottom at almost twice that level? Moreover, IF we again
reach historical cycle bottom experience so clearly visible in the chart on
starts, we're set to drop another maybe 45% from here. Has the market already
priced that in? Again, we think not. If the bulls are correct and stabilization/bottoming
has occurred, as we are increasingly hearing, then this will be the shortest
and most shallow down cycle for housing starts on record in a half century
at least. Just ask yourself, set against the context of historical experience,
are you willing to bet the bottom in starts has already arrived? (Hint: The
deck is stacked heavily against you if you called a bottom. Want to try again?)

We'll make this quick. We've gone through the same conceptual process with
housing permits as in the case of starts. As you'll see in the chart and in
the data, the results are strikingly similar to the starts data and historical
message.

Historical Housing Permits Cycles

Peak

Trough

Duration

% Decline

2/64

11/66

33 mos.

50.0%

12/72

3/75

28 mos.

70.7

6/78

10/81

40 mos.

63.1

2/84

1/91

83 mos.

60.4

AVERAGE

46 mos.

61.1%

1/06

?

11 mos. so far

31.4% so far

For now, history is very strongly suggesting to us that the bottom calling
game in the residential real estate cycle is still in the early innings. As
with most asset cycles, we fully expect the real bottom in residential real
estate to come when everyone stops the headline media bottom calling. Exactly
how it played out with tech stocks over the 2000-2002 period. The pattern of
human behavior surrounding cycles of asset class price movements never changes.
As Jesse Livermore once said about the financial markets, "only the wallets
do (change)". Remember, the real bottom comes when no one is any longer calling
for it. We've got a ways to go yet. But the story clearly does not end with
starts and permits by any means.

At least for now, and remember we're currently in the midst of the slow calendar
period for real estate sales, inventory remains an issue. A big issue. In terms
of new homes under construction, isn't it clear that we are simply barely off
of major cycle highs at this point? It sure as heck appears so. And this is
what Bob Toll calls "dancing on the bottom of the cycle"? With all due respect,
we beg to differ. In our view of life, THE issue for both public and private
builders at this point is stranded capital, plain and simple. It just so happens
that our home state of California is a poster child for this issue. For many
a home builder in the wonderful golden state, per lot sunk costs prior to sticking
a backhoe in the ground to dig a T-footing foundation can run into six figures
without even breathing hard. Entitlement, permit, environmental, utility hook-up,
infrastructure costs, etc. have been and continue to be huge. Municipalities
have clearly partaken in the current real estate cycle largesse in a big way
vis-à-vis fees and costs assessed builders. So when the cycle music
stops, many a builder may find itself with huge sunk costs in what are literally
buildable lots of the moment, and that's about it. What do builders faced with
significant stranded capital do at the top of a cycle? Build faster and move
the inventory. It's simply economics 101. If you saw the recent housing starts
report, you know exactly what we're talking about. Starts up above expectations,
but permits clearly down. In terms of stranded capital in the homebuilding
business, it's start'em, build'em and sell'em at this point. It's no wonder
the following chart looks as it does. Although we're not industry experts by
any means, it sure appears to the untrained eye that we are nowhere near "stabilization",
let alone any type of definitive bottom.

In addition to the current level of new homes under construction, the character
of housing inventory is further illuminated by the sheer nominal number of
homes for sale in the US, again remembering that the current is the slow period
for sales. Interestingly, but certainly not surprising by any means, is the
fact that the percentage of homes put up for sale in 2006 with either expired
listings or taken off the market were at a level not seen in many a moon. Will
these folks give selling a second shot in 2007? If so, it's a pretty darn good
bet that we've not yet seen the top for this indicator in the current cycle.
As is clear, current levels of US homes for sale is really light years above
prior historical peaks. And against this context, mainstream commentators are
calling for a bottom in housing? C'mon, do you think we're complete idiots?

As a final corollary to residential housing inventory and just where we are
in the current cycle is the following historical view of months supply of houses
on the market at current sales rates. A few comments if you don't mind. First,
looking back over history, we're at a relatively important juncture here. Every
single time over the last forty years at least that months supply of homes
for sale has been at eight months or above, we've either been entering or in
an official recession. No exceptions. We're in the low six month range right
now, but it sure seems a good bet this goes higher given the extent and magnitude
of the prior up cycle. For now this remains to be seen. Moreover, please be
aware that quite importantly, cancellations are not counted in this
measure. You already know that it's not uncommon for cancellation rates at
the moment among many of the large public homebuilders to run in the 40%+ range.
That's one big number.

Secondly, at least in terms of historical experience, spikes in this measure
have preceded price softness or declines. After all it's only human nature
in action. The first behavioral stage of every asset class cycle decline is
denial. And the denial of the moment is over price. Sellers are reluctant to
drop prices and buyers reluctant to pay current prices. The character of this
data series moving into 2007 should be quite the "tell" as to how the housing
cycle plays out.

Finally, notice in the chart above that at prior cycle peaks in the number
of homes for sale in the mid-1970's, early 1980's and late 1980's, months supply
of homes for sale was well above current cycle experience so far. The explosion
in current cycle number of homes for sale suggests months supply at present
is nowhere near a peak. We'll just have to see how it all unfolds.

We'll stop here. As you know, we could continue on for pages with charts and
commentary pointing out the very meaningful differences in current cycle dynamics
relative to historical cycle bottoms. The simple message is that unless we
are about to very meaningfully depart from what has been very consistent historical
experience, the housing cycle isn't even close to a bottom right here. And
yes, these facts certainly will not stop the CNBC carnival barkers from attempting
to attract "takers" based on one-off sound bites moving forward. But in terms
of the real world, at the end of 3Q 2006, household real estate holdings totaled
just shy of $20.5 trillion. Household holdings of common stocks in the same
period registered $8.3 trillion. Bottom line? The housing cycle is the key
to the real US economy in 2007 as transmitted through US consumer behavior.
So far, US consumers have weathered the increasingly darkening skies for domestic
real estate quite well. As of 3Q 2006, our friends at Freddie Mac tell us that
89% of refis done were cash out refis. Households clearly continue "to believe".
But cycle dynamics sure seem to suggest that "belief" in residential real estate
as an ever producing fountain of wealth creation will be more than tested in
2007. Can US households and ultimately investors in US financial markets handle
the truth? We're about to find out dead ahead.

Action And Reaction...As is very important to remember at all points
in time, what happens in the real economy and what happens in the financial
markets, that are ultimately a reflection of economic reality, can be two different
things over very short periods of time. As investors, we need to constantly
distinguish between the personal need to be right in terms of fundamental outlook
and yet putting into actual practice what it takes to make money. In the financial
markets, as is true in many physical laws of nature, for every action there
is a reaction. And set against the reality of the housing cycle we indeed expect
reaction.

Again, although it's a very simplistic comment, the Fed will not sit still
and watch housing deteriorate to any meaningful degree in 2007. Why? Because
at least historically, the correlation between the US housing cycle and US
consumer spending dynamics is about as tight as anything we've ever seen. You
can see it clearly in the relationship between the NAHB housing index (National
Association of Homebuilders) and the year over year rate of change in real
personal consumption expenditures (consumer spending) below.

As has been the case for so long now, liquidity will be the order of the day
in terms of counter cyclical artillery to hold back the fallout influence of
any further housing cycle deterioration. As we mentioned, it's already well
under way. The following chart is again the historical months supply of homes
for sale now set against the historical movement of the Fed Funds rate. Highly
correlated directionally? You bet.

But what seems quite the differentiating factor in the current period is that
during this cycle housing price acceleration was not choked off in large part
by restrictive credit. Short rates have clearly influenced the cost of adjustable
financing, but the cost of conventional financing is up maybe 100 basis points
at present from its current cycle lows. And it's really only in the past month
or so that very questionable subprime activities have begun to become problems
as witnessed by shifting credit spread activity. Question. Is it really a 100
basis point increase in the cost of conventional financing that is responsible
for bringing the greatest residential real estate cycle in history to its knees?
We know at this point that current cycle excess has been in both mortgage credit
availability and physical supply. So as the current housing cycle continues
to play out, we anticipate the Fed will fight any type of continued deterioration
every step of the way, as was exactly the case with the tech/greater equity
bust early in this decade. Given the leverage both in residential real estate
and the US economy as a whole, they really have no other alternative at this
point except monetary inflation. Remember, these are not the policemen, but
the provocateurs of price inflation. So from a practical standpoint, we need
to monitor Fed artillery supply (monetary/liquidity expansion) as well as direction
of rounds being fired (to where does the liquidity flow?). And this can and
will have a direct impact on financial market outcomes. The more the Fed/Treasury/Administration/Wall
Street attempts to fight what we believe will be continued deterioration in
the real world of US residential real estate with monetary inflation, the more
excess liquidity driven financial speculation may unfold. This has been our
immediate history, so why not our immediate future?

We'll leave you with an excerpt from a recent (November '06) Fortune interview
with Treasury Secy. Paulson. And we'll also leave you with a question to ponder.
Is this personal conjecture on the part of Paulson, or is this simply implicit
policy at this point?

Aren't you concerned that GDP growth dropped to 1.6% in the latest quarter?
That's kind of anemic, and we've seen a downturn in the housing market.
Convince us we're not going to have a recession next year.

"I can't convince you. But as I looked at the third quarter, I felt good
because I saw a major correction in the housing market, and I knew that
was going to take more than one percentage point off GDP. And then I'm
looking at the rest of the economy - strong corporate profits and investment,
good growth outside the U.S., strength in the construction sector away
from housing, and then an equity market that has gone up and added $1
trillion in value.

I know how much people care about housing. But I would be quite
hopeful that through 401(k) plans, pension plans, and elsewhere that
the average American is feeling an uplift from the appreciation of the
equity market that would be very offsetting to any potential decline
in housing."

Please remember, the reality of the US economy and how that reality is mirrored
over the short term in financial markets can be two very different things.
Being right and making money as investors can be two different things. Especially
in today's world of interest rate and credit derivatives mushroom clouds. We
know exactly how the Fed/Treasury/Administration/Wall Street reacted to the
tech stock bust. Should be really expect anything different conceptually in
terms of a reaction to a housing downturn? We think not. Listen to what Paulson
said above. Listen. The decline in housing is not going to occur without one
big "reaction". Capiche?

Although we are far from being in possession of a crystal ball, given the
immediate US circumstances we have just described, what does this portend thematically
looking ahead? Personally, we expect sector and overall financial market volatility
to increase looking forward. Regardless of the US residential real estate cycle
outcomes near term, the clear theme of meaningful long term economic growth
in emerging markets (China, India, Brazil, Russia, etc.) remains fully intact.
Any type of meaningful softness in these markets driven by US consumer behavior/credit
cycle dynamics over the short term should be seen as long term opportunities.
If the Fed accelerates its monetary reflation efforts from here, non-dollar
investment vehicles as well as investments negatively correlated with the US
dollar are deserving of consideration. Global labor arbitrage opportunities
remain intact. Any pressure on US corporate profits will only increase labor
arbitrage activities. Hence, cash rich global blue chips truly focused on enhancing
shareholder value (as opposed to simply supporting stock options programs)
remain of interest. Total rate of return, yield tilt, and a defensive sector
focus in US markets appears the appropriate stance at this point. Set against
historical context, the length of the current economic expansion and equity
market up cycle are long in the tooth. Finally, and this is always the case,
well defined and executed risk management disciplines are paramount. Long term
investment survival is not about hitting home runs. It's all about consistently
not striking out.

We wish you and your families a healthy, peaceful and prosperous New Year
ahead.

Contrary Investor is written, edited and published by a
very small group of "real world" institutional buy-side portfolio managers
and analysts with, at minimum, 20 years of individual Street experience. Our
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